Quarterly Fund Commentary

Market Sector Update

The Federal Reserve (Fed) officially ended quantitative easing (QE3) in December. The focus now is on the timing of the first fed funds rate increase expected in 2015. The current expectation is for a 25 basis point rate increase in June or July, but this date is very data dependent.

Given the strong upward revision to third quarter gross domestic product and what looks like a fairly strong fourth quarter, a June start date for Fed tightening seems reasonable right now. If U.S. economic growth in early 2015 is brought down by the extreme weakness in Europe and the emerging markets, then the lift off date for Fed tightening could be delayed.

The dramatic collapse in the price of oil has had both negative and positive effects to U.S. economic growth. States with economies dependent on oil exploration and production could easily fall into a recession in 2015. States that are net consumers of oil have already begun to see a very positive effect to lower oil prices.

During the fourth quarter we saw another dramatic rally at the long end of the Treasury bond market. Continued weakness in Europe and a dramatic selloff in emerging market bonds lead to a strong flight to quality trade into the Treasury market. The short end of the curve is much more influenced by the actions at the Fed and did not see the same rally.

Portfolio Strategy

Even as the Fed begins to raise rates, we believe the strong flight to quality trade should continue to keep Treasury yields at the long end relatively low. It does not take much new news for the market to make a significant move to higher or lower rates. We think investment grade corporate credit offers the best riskadjusted spread cushion of the major sectors in the high-grade fixed income market.

We have been overweight corporates over the last few years and plan to continue this overweight position as 2015 begins. With economic conditions improving in the U.S., we expect relatively stable corporate bond spreads on investment grade bonds.

The new normal appears to be significantly less net new issuance of mortgage-backed securities. As a result, mortgage spreads continue to be tight. Our mortgage holdings are structured to experience less extension risk during periods of rising interest rates and we continue to look for opportunities to increase agency holdings.

We remain underweight Treasury bonds, especially at the very short end of the curve, and overweight high-grade spread product. We are committed to seeking stable income at the best available price.

Outlook

The Fed has added “patient” to its description of the timing of its rate increase. Currently, the market does not anticipate the Fed to begin raising the fed funds rate until mid-2015. However, this is a very volatile and data dependent prediction. With the short end of the yield curve anchored by the low fed funds rate, we expect to see continued volatility in the middle and longer end of the curve.

Even slight changes in the U.S. economic outlook can have significant short-term effects on longer duration securities. We anticipate relatively stable economic growth going into 2015, led by a robust consumer.

While the Fed still appears to be willing to keep rates low for a long time, they have indicated a growing desire to begin to normalize monetary policy. They have also indicated the risk of higher inflation is less of a concern than the threat of renewed economic weakness.

In the past, sustained bond bear markets have not been able to get underway until the Fed tightening cycle is imminent. We expect to keep our duration neutral to our benchmark as 2015 begins. We anticipate continued demand for spread product within the high grade bond market. We are willing to take additional credit risk when we believe we are being compensated to do so.

The opinions expressed in this commentary are those of the Portfolio's manager and are current through December 31, 2014. The manager's views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.

Risk factors. As with any fund, the value of the Portfolio's shares will change, and you could lose money on your investment. An investment in the Portfolio is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Portfolio may fall as interest rate rise. These and other risks are more fully described in the Portfolio's prospectus.

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Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or click here. Please read the prospectus or summary prospectus carefully before investing.

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